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South v. Baker and the Race to the Courthouse in Caremark Actions (Part 2)

So what are the implications of this approach?

The decision is thoughtful in limiting the analysis to Caremark actions.  Those claims are tough to bring under the best of circumstances.  The court clearly believes that if the race to the courthouse can be slowed, shareholders (and their counsel) will proceed in a more deliberate fashion and, at least sometimes, will opt not to file Caremark claims. 

That is not, however, the likely outcome.  Shareholders still have an incentive to file quickly.  They will argue that they have alleged sufficient facts to withstand a motion to dismiss.  Assuming they are correct, they benefited from the fast filing.  Assuming they are wrong, they suffer nothing more than the usual consequence of a dismissal (although their dismissal will be with prejudice).  

To the extent representation is deemed inadequate, shareholders who do not file quickly but instead conduct a meaningful investigation (presumably by invoking their inspection rights).  They can then  file a claim in the same action.  Thus, derivative actions involving Caremark allegations are likely to produce a class of plaintiffs who file quickly and a class of plaintiffs who invoke their inspection rights.  The former will presumably succeed sometimes, albeit in rare circumstances, and when they do not, the latter will be in a position to file a follow up action.

It is possible that the second group of plaintiffs will decide not to file once they have completed the inspection process.  They may not uncover sufficient additional facts to allow them to adequate differentiate their complaint from the one filed by the first group of shareholders.  This seems to be what the Vice Chancellor hopes will happen.  Yet this "discretion" is for the most part unlikely.  Given the existing predilection to file even without significant investigation, it presumably will not be difficult for subsequent plaintiffs to find enough additional evidence to justify a second complaint. 

The effort by the Vice Chancellor is a worthy one.  He was careful to limit the approach to Caremark actions.  Moveover, he did not require shareholders to invoke inspection rights.  Instead, he more broadly required a "meaningful investigation," something that will often but not always mean the use of inspection rights.  

The real consequence of the risk of plaintiffs who file without adequate homework is a dismissal that ultimately bars other shareholders who do engage in the requisite investigation.  The Vice Chancellor has left open the door for those shareholders.  Morover, as the practice develops, the more sophisticated firms may opt increasingly to represent shareholders who prefer to conduct a more thorough investigation before filing an action. 


South v. Baker and the Race to the Courthouse in Caremark Actions (Part 1)

South v. Baker, 2012 Del. Ch. LEXIS 229 (Del. Ch. Sept. 25, 2012) represents another step in VC Laster's efforts to slow the race to the courthouse at least in cases involving Caremark allegations.  It is in many ways a refinement of the analysis in Pyott

In this case, he created a presumption that counsel filing derivative claims containing Caremark allegations would be subjected to a presumption of inadequate counsel unless the suit was preceded by an effort to obtain documents under Section 220.  The analysis was an attempt not only to slow the race to the courthouse but also to reduce the number of lawsuits filed.  There may be some impact on the latter but not on the former. 

The case arose following statements by Hecla Mining Company that lowered projections for silver production and a statement by the United States Mine Safety and Health Administration ("MSHA") that disclosed safety violations by Hecla.  The statement was quickly followed by two securities cases alleging violations of Rule 10b-5 and seven derivative suits.  Some were filed in Delaware and some in Idaho, both in state and federal court.  Two stockholders who did not file suit sought documents under Section 220.  With respect to the case in Delaware, plaintiffs alleged a Caremark claim. 

Defendants sought dismissal and the court found that the complaint lacked "particularized facts supporting a reasonable inference that a majority of the Board faces a substantial risk of liability".  As a result, plaintiffs had not sufficiently alleged demand futility.  The court then addressed the consequences of the dismissal. 

The Vice Chancellor had a point to make.  In his court, those who did not precede a Caremark claim with the exercise of inspection rights risked punishment, at least where the failure was unexplained . "Wholly missing was any explanation as to why the Souths did not use Section 220 before filing suit, as the Delaware Supreme Court has recommended repeatedly."  As a result, "dismissal of the complaint with prejudice as to the Souths is a fitting consequence that does not seem likely to work any prejudice on the corporation."

A dismissal with prejudice, however, did little to slow the race to the courthouse.  Plaintiffs still had an incentive to file quickly, even if they risked dismissal.  The Vice Chancellor, however, addressed this incentive.  He noted that dismissal with prejudice of someone who filed quickly essentially penalized the shareholders that took steps to invoke their inspection rights. 

As noted, good faith disagreements exist over the extent to which a dismissal with prejudice as to the named plaintiff could have preclusive effect on the efforts of other stockholders to bring suit, including those stockholders who have attempted to use Section 220. After considering the Souths' pleading, it concerned me that if a different stockholder carefully investigated the events at the Lucky Friday mine, uncovered a meritorious claim, and wished to pursue it, the potential combination of a broad preclusion rule together with all-too-predicable results of the Souths' litigation strategy could bar the diligent stockholder from suing.

He ultimately decided that the dismissal with prejudice applied only to the existing plaintiffs, not to other possible plaintiffs.  To reach that result, he concluded that "another stockholder still can sue if the first plaintiff provided inadequate representation."  He then made a "finding of inadequacy" and, as a result, determined that the dismissal of the complaint "should not have preclusive effect on the litigation efforts of more diligent stockholders".  

The finding of inadequacy was grounded on the failure of plaintiffs to first seek to inspect documents under Section 220.  The failure, according to the court, created a presumption that the shareholder had acted in a disloyal fashion. See Id. ("When a stockholder rushes to file a Caremark claim without first conducting an adequate investigation to determine whether or not there is a connection between the corporate trauma and director action or conscious inaction, the stockholder acts contrary to the interests of the corporation but consistent with the interests of the plaintiffs' firm that files the suit. This recurring scenario supports a presumption that the plaintiff has acted disloyally and is not an adequate fiduciary for the corporation.").

The presumption was limited to Caremark claims.  Id.  ("This requirement differentiates a Caremark claim from other types of derivative actions in which a plaintiff challenges a specific and identifiable board decision. In such a case, a plaintiff may well be able to plead particularized allegations without using Section 220 that are sufficient to survive a Rule 23.1 motion to dismiss"). 

The court left open the possibility that the presumption could be rebutted.  The shareholder could either produce "evidence that calls into question the requisite facts giving rise to the presumption" or could rebut the presumption by "producing evidence directly contrary to the presumptive inference."  The former could be accomplished by alleging facts "showing that the plaintiff did not file hastily and conducted a meaningful and thorough investigation."  The latter could be accomplished by adducing facts demonstrating that a quick filing "benefited the corporation and not just the plaintiffs' law firm."  Plaintiffs, however, were unable to rebut the presumption. 

We will discuss the implications of this decision in the next post.


The Race to the Courthouse: La. Mun. Police Emples. Ret. Sys. v. Pyott (Part 7)

We are discussing La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012) and its potential impact on Caremark style derivative suits.

We would be remiss if we did not consider the Caremark analysis employed by the court in Pyott.  In what has to be more unusual than a finding that the board violated the Blasius standard, the court concluded that the shareholders in Pyott sufficiently alleged a Caremark violation.  Such a claim could arise where the alleged conduct involved conscious behavior to cause a violation of the law.  As the court explained:

by consciously causing the corporation to violate the law, a director would be disloyal to the corporation and could be forced to answer for the harm he has caused. Although directors have wide authority to take lawful action on behalf of the corporation, they have no authority knowingly to cause the corporation to become a rogue, exposing the corporation to penalties from criminal and civil regulators. Delaware corporate law has long been clear on this rather obvious notion; namely, that it is utterly inconsistent with one's duty of fidelity to the corporation to consciously cause the corporation to act unlawfully. The knowing use of illegal means to pursue profit for the corporation is director misconduct.

The plaintiffs in Pyott sufficiently alleged this type of behavior.  The plaintiffs alleged that the board approved business plans "premised on illegal activity."  According to the court:  "The Board kept Allergan's business plan in place even after the . . . FDA inquiries illustrated the extent of Allergan's regulatory exposure."  These and other allegations were sufficient to "reasonably infer that the Board knowingly approved and monitored a business plan that contemplated illegality." As the court concluded:  "At the pleadings stage, I believe the plaintiffs are entitled to the reasonable inference that the Board oversaw company-wide efforts to promote off-label use of Botox for treating migraine headaches, which was not an FDA-approved use at the time."

The facts, therefore, look to be unusual.  It will be a decidedly rare case where plaintiffs can present sufficient allegations that a board knowingly approved a business plan that "contemplated illegality."   Nonetheless, the court took the same allegations examined by the California court and reached a different outcome.  Moreover, the court did so in a manner that benefited shareholders.  Were there to be a few more cases with similar outcomes, this Blog might have a harder time justifying the management friendly appellation usually given to the Delaware courts. 

Primary materials can be found at the DU Corporate Governance web site.


The Race to the Courthouse: La. Mun. Police Emples. Ret. Sys. v. Pyott (Part 6) 

We are discussing La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012) and its potential impact on Caremark style derivative suits.

What are the implications of the decision?  First, the case could be criticized because it was not limited on its face to Caremark actions.  The decision seemed to impose a duty to inspect in all derivative actions.  A subsequent case, as we will discuss tomorrow, however, made clear that the analysis was limited to Caremark actions, circumstances where the need to inspect may be stronger than in other types of derivative suits.  Moreover, the subsequent case also clarified that the presumption against rapid filing of Caremark actions could be rebutted.  So we will put those criticisms aside. 

The clear intent of the opinion is to force counsel for shareholders to slow down the race to the courthouse, be more deliberative in formulating a case, and, ideally, actually deciding in some cases not to bring an action.  Will this occur?  Yes and no.

Clearly, counsel bringing these cases in Delaware will know that they will receive short shrift in VC Laster's courtroom if they do not first invoke inspection rights.  Whether the other jurists in Delaware will follow his approach remains to be seen. 

But invoking inspection rights will delay the filing only in Delaware.  Unless courts in other jurisdictions apply the same approach, there will be no impediment to filing a quick action in a non-Delaware jurisdiction.  To the extent that these plaintiffs survive a motion to dismiss, they will control the litigation and gain everything in discovery that the Delaware shareholders tried to obtain through an inspection demand.  As a result, this approach may in fact encourage litigation outside of Delaware.  See 2012 COLUM. BUS. L. REV. 427, 491 (2012) ("As we document elsewhere, since the mid-1990s, the rate of corporate litigation involving Delaware companies has increased, and the proportion of cases filed in Delaware courts has fallen.").

To the extent the non-Delaware court dismisses the action, Pyott makes clear that in at least one courtroom, shareholders will suffer the same fate unless they have invoked inspection rights.  At the same time, this obligation will at least in some cases result in a stronger complaint being filed in Delaware than in the non-Delaware jurisdiction.  It is possible that a few of them might survive a motion to dismiss, something that occurred in this case.     

That possibility depends upon the Delaware courts.  To the extent that Pyott effectively mandates the use of inspection rights as a precondition to a Caremark action in Delaware, it is effectively imposing on plaintiffs additional cost and additional delay.  The costs and delay will only be beneficial if in fact they sometimes result in a case surviving a motion to dismiss that otherwise would not have. 

This occurred in Pyott.  But as we noted, counsel for shareholders in the California action received all of the material obtained from the inspection request by other shareholders.  In other words, the Delaware case was allowed to go forward but there was no evidence that the complaint was any better than the one dismissed in California.  To the extent the Delaware courts continue to dismiss almost all of the Caremark claims brought by shareholders, Pyott potentially makes the process more expensive without providing any compensatory benefit to make up for these additional costs.

Primary materials can be found at the DU Corporate Governance web site.


The Race to the Courthouse: La. Mun. Police Emples. Ret. Sys. v. Pyott (Part 5)

We are discussing La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012) and its potential impact on Caremark style derivative suits.

Having identified the idealized version of the shareholder derivative suit (at least in a Caremark context), the court sought to turn this version into the reality. 

In reviewing the facts of the case at hand, the Chancery Court concluded that the firms filing the California actions "failed to provide adequate representation."  As a result, the dismissal in California was not determinative of the motion to dismiss the action in Delaware.

The characterization of California counsel was not, in the end, based upon the merits of the complaint but solely from the decision to file quickly.  The case, the court reasoned, "exemplif[ied] the race-to-the-courthouse problem."  Within 48 hours of the settlement between Allergan and the Department of Justice, a derivative suit was filed in Delaware.  Three additional complaints were filed within weeks of the initial suit in California. 

The complaints were "filed hastily for one reason only: to enable the specialized law firms to gain control of a case that could generate legal fees."  As a result, the company was forced to "fund the teams of the lawyers hired by the individual defendants to respond in each jurisdiction, address coordination issues, and brief parallel motions to dismiss." The court viewed the actions of the California law firms as a failure to "fulfill the fiduciary duties they voluntarily assumed as derivative action plaintiffs." 

Presumably California counsel should have delayed filing and invoked inspection rights.  Had they done so, they would have had additional information to use in deciding whether to bring the action.  Yet in fact, they had that very information.  A shareholder in Delaware had successfully made a demand to inspect records at Allergan and the materials were given to the plaintiffs in the California actions.  California plaintiffs "used the materials to file an amended complaint. and used in the amended complaint."

So it wasn't about the inadequacy of the complaint.  It was about the decision of the California plaintiffs to file quickly.  As the Vice Chancellor opined:

the fast-filing plaintiffs already had shown where their true loyalties lay. Asking for and receiving the benefit of another lawyer's work did not rehabilitate them. It rather evidenced their continuing desire to control the case. In this regard, I disagree that the policy goal of encouraging plaintiffs to use Section 220 will not be undercut by a rule that affords priority to fast filers if the corporation gives them the same books and records that a diligent stockholder fought to obtain. . . . Under the rule enunciated in King I, the issue would not arise because stockholders like the California plaintiffs would not be able to file fast, suffer dismissal, and then ask for books and records to try again.

In other words, the case amounted to a warning.  Counsel bringing a Caremark action without first invoking inspection rights (and presumably undertaking some kind of deliberative process over whether to bring the case) incurred the risk that a Delaware court would view them as failing to provide adequate representation.

Primary materials can be found at the DU Corporate Governance web site.


The Race to the Courthouse: La. Mun. Police Emples. Ret. Sys. v. Pyott (Part 4) 

We are discussing La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012) and its potential impact on Caremark style derivative suits.

What about derivative suits from the shareholder perspective?  As the court described, shareholders seek to "displace the board's authority."  Particularly in Caremark style cases, they have a difficult burden of showing a relationship between some type of corporate calamity and the board of directors. Ideally, shareholders would benefit from this type of suit only "if there was a risk-adjusted prospect of a net-positive recovery."  

To accurately engage in this calculation takes time.  Shareholder would need to "hire well-qualified counsel" who would need to "conduct an investigation and seek books and records".  With the requisite documents in hand, they could "evaluate whether it made sense to sue." 

The books and records might show that the board had an appropriate monitoring system in place, but that the system did not alert the board. Or the books and records might show that despite their good faith efforts, the directors were misinformed or misled. Under these or other circumstances, the hypothetical stockholder collective logically might decide not to sue, preferring to leave their elected fiduciaries to the task of remedying the harm suffered by the corporation and dispensing with expensive litigation that likely would founder on Rule 23.1. 

There also might be information obtained in the inspection request that strengthened the suit.

if the books and records showed director misconduct, then the stockholders could decide to pursue a claim. Their counsel at that point would be well positioned to plead demand futility and survive a motion to dismiss. Importantly for all concerned, the costly process of briefing and arguing motions to dismiss would take place once, based on the stockholders' post-inspection complaint.

In other words, a more deliberative process might result in a determination that a suit should not be filed.

Primary materials can be found at the DU Corporate Governance web site.


The Race to the Courthouse: La. Mun. Police Emples. Ret. Sys. v. Pyott (Part 3)

We are discussing La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012) and its potential impact on Caremark style derivative suits.

The harm from fast filing of complaints in derivative suits is, according to the court in Pyott, the filing of meritless cases.  These filings impose on companies unnecessary defense costs.  This in turn imposes costs on shareholders.  The problem is apparently limited to shareholder initiated actions.  It does not apply to the process used by the board in deciding whether to bring an action. 

Absent "doubt" about the "directors' ability to make disinterested and independent decisions about litigation," the court reasoned, the board is "optimally positioned to make decisions on behalf of the corporation and, if appropriate, pursue litigation."  Directors are in a position to investigate, to access internal information, and "[p]erhaps most significantly, the board can take into consideration and balance the interests of multiple constituencies when determining what outcome best serves the interests of stockholders."

This analysis gives too much credit to the system of board review.  It is in fact accurate to suggest that the board has more information and is potentially in a better position to weigh all of the competing interests.  But what it can do and what it does are two different things.  In fact, boards invariably seek dismissal of derivative suits.  See La. Mun. Police Emples. Ret. Sys. v. Morgan Stanley & Co., 2011 Del. Ch. LEXIS 42 (Del. Ch. March 4, 2011) (noting that directors "typically" refuse demand for litigation in derivative context).

In other words, the analysis in this case deals with the costs associated with an excessive number of derivative suits brought by shareholders.  What it does not address are the costs associated with an inadequate number of suits brought by management.  

rimary materials can be found at the DU Corporate Governance web site.


The Race to the Courthouse: La. Mun. Police Emples. Ret. Sys. v. Pyott (Part 2)

We are discussing La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012) and its potential impact on Caremark style derivative suits. 

The case involved derivative suits filed against Allergan following a guilty plea to a criminal misdemeanor and the payment of $600 million in civil and criminal fines.  Multiple suits were filed, including one in Delaware (filed by the Louisiana Municipal Police Employees' Retirement System) and another in California.  The California action was dismissed without prejudice and then dismissed a second time with prejudice. 

In Delaware, the action was stayed pending an attempt to inspect the books and records under Section 220 by a shareholder, UFCW Local 1776.  UFCW eventually intervened and, along with other plaintiffs, filed a second amended complaint (consisting of 84 pages and 241 paragraphs). 

Defendants sought dismissal.  In part, they based their argument on the actions of the California court.  They asserted that the decision had collateral estoppels effect.  The Chancery Court in the end said it did not but in the course of the opinion took a swipe at the "race to the courthouse" dynamic that apparently takes place with respect to derivative suits.    

The court acknowledged that the race was a product of the structural nature of derivative suits.  Derivative suits were, as the court reasoned, often brought by firms with expertise in the area.  Id.  ("For publicly traded Delaware corporations, the enforcement of fiduciary obligations is largely carried out by specialized plaintiffs' firms who bring claims on a contingent basis.").  These firms were compensated in the form of fees but only if they achieved results. 

In order to obtain the requisite "results," these firms had to obtain control over the litigation.  Control, however, often went to the first to file. This imposed pressure on counsel to file suits quickly.  As the Vice Chancellor put it:  "No role, no result, no fee."

Rapid filing could be beneficial but only, according to the court, in a narrow set of circumstances where expedited action is called for.  Id.  ("When fast-filed complaints follow the announcement of a transaction or other event that likely will require expedited litigation, they at least perform the beneficial function of identifying the firms who wish to compete for leadership status. In a quickly evolving deal setting, fast-filing enables a leadership structure to be put in place so that expedited litigation can begin in earnest."). 

Where, however, expedited action was not required, "any administrative benefit [from fast filing] disappear[ed]."  The reason?

[H]astily filed complaints have little chance of surviving a Rule 23.1 motion, yet the defendant fiduciaries must respond, and the corporation must underwrite the costs of defense, either directly through indemnification and advancement or indirectly through insurance.

In other words, the presumption is that quick filed cases will be meritless.  Rapid filing, therefore, requires companies to incur defense costs in connection with meritless cases.   

Primary materials can be found at the DU Corporate Governance web site.


The Race to the Courthouse: La. Mun. Police Emples. Ret. Sys. v. Pyott (Part 1)

It has been a long time coming but the decision by VC Laster in La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012) deserves some comments.   

The case turns mostly on the right of Delaware courts to decide whether the dismissals of derivative suits in other jurisdictions have preclusive effect within the state.  At least where the action was brought by different shareholders, the Chancery Court concluded that an earlier dismissal by California courts was entitled to some weight but otherwise did not bind the Delaware judiciary.  Unsurprisingly for a proud and talented judiciary, they would make up their own mind. 

Yet the opinion contains much more than a discussion of this one issue.  The decision strongly encourages shareholders to bring their action in Delaware and strongly encourages them to avoid filing until after having made a demand to inspect corporate records, at least in cases alleging a Caremark violation.  The court also showed the benefits of this approach by upholding a Caremark claim. 

The case is an effort to slow down the race to the court house in certain types of derivative suits.  It is trying to impose on plaintiffs a more deliberative process that fundamentally pushes shareholders to inspect documents before deciding whether to file an action.  We will assess the likely effectiveness of this approach in subsequent posts. 

Primary materials can be found at the DU Corporate Governance web site.


Delaware Law, Voidable Transactions, and the Implications for the Duty of Loyalty: SPTA v. Volgenau 

One classic example of a shift in Delaware law to the detriment of shareholders occurred in connection with a misapplication of Section 144 of the DGCL.  The provision deals with transactions involving director conflicts of interest and provides that no agreement shall be "shall be void or voidable" as a result of the conflict where the transaction is approved by shareholders, disinterested shareholders, or is otherwise fair. 

The meaning of the provision is plain.  It was intended to prevent conflict of interest transactions from being voidable (something that was possible under the old common law standard).  Nonetheless, Delaware courts have misapplied the provision and used it to significantly change the standard of review for conflict of interest trnasactions.  The courts have concluded that Section 144, if properly used, results in the application of the duty of care rather than the duty of loyalty to a conflict of interest transaction.

The incorrect nature of the interpretation is clear from the language of the statute (it speaks only to voidability) and from the standards set out in the statute.  Voidability is avoided through a showing of fairness, approval by disinterested directors, or approval by shareholders.  Despite suggestions by the Delaware courts to the contrary, the statute does not require approval of the transaction by disinterested shareholders.  Thus, if Section 144 were read to change the standard of review (instead of addressing only voidability), it would effectively be allowing a change in the standard in the unjustifiable circumstances of approval by interested shareholders.  For a more detailed discussion of this issue, see Returning Fairness to Executive Compensation

We note all of this because of the recent decision by the Chancery Court that shows how Section 144 ought to work.  In Southeastern Pennsylvania Transportation Authority v. Volgenau, 2012 Del. Ch. Lexis 206 (Del. Ch. Aug. 31, 2012), the court had to interpret Section 124, the ultra vires provision.  The provision provided that "[n]o act of a corporation . . . shall be invalid by reason of the fact that the corporation was without capacity or power to do such act" but provided that the lack of authority could only be raised in certain circumstances, including "a proceeding by a stockholder against the corporation to enjoin the doing of any act or acts".

Plaintiffs challenged a merger approved by the board and argued that the transaction was ultra vires because it violated the articles of incorporation.  Defendants sought dismissal of the action alleging that plaintiffs had not met the requirements of the statute because the action was for damages, not an injunction.

The court declined to dismiss the action, however.  It noted that Section 124 spoke to voidability, that is a claim "that the act could not occur."  Actions by corporations that are not voidable under the statute could still be challenged as a violation of the board's fiduciary obligations.  The court noted that the Section did not speak to fiduciary obligations.

The General Assembly could have stated in 8 Del. C. 124 that a director's decision to cause a corporation to take an act in violation of the corporation's certificate of incorporation shall not constitute a breach of that director's fiduciary duties. But the General Assembly did not do that. Instead, it enacted a statute directed solely to the acts of corporations that are beyond challenge or that may only be challenged in a limited manner.

The same paragraph could have been written about Section 144.  The provision references voidability but says nothing about fiduciary duties.  Nothing in Section 144 addressed the right of shareholders to challenge transactions that were found not to be voidable.  In other words, the standard of review for these transactions is a matter of common law, not a matter of statutory mandate. 

The inapplicability of Section 144 matters.  To the extent that the courts want to provide benefits to boards that use a disinterested approval mechanism, they have the flexibility as a matter of common law to decide those benefits.  Delaware courts already provide that disinterested approval of transactions with controlling shareholders (a type of transaction not expressly covered by Section 144) will not result in a shift from the duty of loyalty to the business judgment rule but simply results in a shift of the burden of showing unfairness to the challenging shareholders. 

A shift in the burden would mean that fairness still mattered.  The terms of the transaction would be relevant to the analysis.  Shareholders would not be limited to the impossible standard of waste.  The result would be a more exacting standard of review by directors and, in the case of executive compensation, downward pressure on amounts.  Yet as long as the courts point to Section 144, they can lay the blame for an inadequate standard of review at the feet of the Delaware legislature. 

Primary materials are posted on the DU Corporate Governance web site


Special Committees and the "Controlled Mindset" -- Americas Mining Corp. v. Theriault (Part 3)

As for the "controlled mindset" analysis of the Chancery Court, the Supreme Court had little specific to say about it. The Court mentioned it a few times and noted that an analysis of entire fairness required the Chancery Court to apply "a disciplined balancing test".  The Court concluded that the record reflected that this "balancing" in fact had occurred. 

The record reflects that the Court of Chancery applied a "disciplined balancing test," taking into account all relevant factors. The Court of Chancery considered the issues of fair dealing and fair price in a comprehensive and complete manner. The Court of Chancery found the process by which the Merger was negotiated and approved constituted unfair dealing and that resulted in the payment of an unfair price.

The case demonstrates that the traditional safeguards -- independent directors and independent advisors -- do not invariably protect shareholders.  Special committees can still be subject to excessive influence of the controlling shareholder. 

Nothing in the opinion, however, suggested any meaningful method of determining when this untoward influence existed.  The use of the term "controlled mindset" was really a conclusion rather than an analytical framework.  Indeed, the determination was reminiscent of Potter Stewart's famous analytical framework, "I know it when I see it."

The case does demonstrate that the special committee approach used by the Delaware courts has significant problems.  Yet the practice of replacing substantive fairness with process is a continuing trend in the development of Delaware law. 

Some primary materials from the Chancery Court are posted on the DU Corporate Governance web site.


Special Committees and the "Controlled Mindset" -- Americas Mining Corp. v. Theriault (Part 2)

The Supreme Court affirmed the approach taken by the trial court with respect to the burden shifting nature of the Special Committee.  The trial court was found to have been correct in assigning the burden of proof only after the trial had occurred.  As the Court reasoned:

The Court of Chancery could not decide whether to shift the burden based upon the pretrial record. After hearing all of the evidence presented at trial, the Court of Chancery found that, although the independence of the Special Committee was not challenged, "from inception, the Special Committee fell victim to a controlled mindset and allowed Grupo Mexico to dictate the terms and structure of the merger." The Court of Chancery concluded that "although the Special Committee members were competent businessmen and may have had the best of intentions, they allowed themselves to be hemmed in by the controlling stockholder's demands."

The inability to resolve the burden until after the trial resulted in "practical problems for litigants".  Nonetheless, it was an inevitable consequence of the standard.  

In affirming the lower court, the justices tried to minimize the impact of their decision.  The Court described the shift in the burden to the shareholders as a "modest procedural benefit" (emphasis in original).  In other words, boards gained only a modest value in seeing the burden shift.  Moreover, the assignment of the burden was not invariably outcome determinative as the facts in Americas Mining illustrated.  See Id.  ("The Court of Chancery concluded that this is not a case where the evidence of fairness or unfairness stood in equipoise. It found that the evidence of unfairness was so overwhelming that the question of who had the burden of proof at trial was irrelevant to the outcome."). 

In fact, a "modest" benefit probably overstated the value that came with the shift in the burden.  Defendants asserted that the failure to determine the burden shifting issue prior to trial would discourage boards from using special committees.  The Court disagreed, citing the value of special committees. 

That argument underestimates the importance of either or both actions to the process component—fair dealing—of the entire fairness standard. This Court has repeatedly held that any board process is materially enhanced when the decision is attributable to independent directors. Accordingly, judicial review for entire fairness of how the transaction was structured, negotiated, disclosed to the directors, and approved by the directors will be significantly influenced by the work product of a properly functioning special committee of independent directors.

In other words, the benefits of a "properly functioning special committee" weren't modest, they were insurmountable.  If the committee was properly functioning, the burden wouldn't merely shift.  IN effect, shareholders would be subject to an irrefutable presumption of fairness.   In effect, the standard of review was not really entire fairness but the business judgment rule. 

Some primary materials from the Chancery Court are posted on the DU Corporate Governance web site.


Special Committees and the "Controlled Mindset" -- Americas Mining Corp. v. Theriault (Part 1)

Americas Mining Corp. v. Theriault, 2012 Del. Lexis 459 (Del. August 27, 2012) got a great deal of press if for no other reason than the eye popping numbers.  The Chancery Court found (and the Supreme Court affirmed) that Southern Peru overpaid for the purchase of a company from a controlling shareholder.  The trial court awarded damages of $2 billion and attorneys fees of $304 million. 

The case also, however, contains some very interesting commentary on special committees.  In general, boards considering proposals from a controlling shareholder understand that the transaction will be reviewed under the entire fairness standard.  A review of entire fairness entails an examination of both amount paid and the process employed (fair price and fair dealing). 

To ensure proper process, directors commonly form a special committee.  The committee typically consists entirely of independent directors and the directors retain independent experts.  Where the company uses a special committee in this manner, the Delaware courts shift the burden to shareholders.  Rather than the board having to show that the transaction was fair, shareholders have to show that the transaction was unfair.  The shift in the burden, however, is based on the efficacy of the procedural protections provided by the special committee.  To the extent the process is somehow flawed, courts will not defer and the burden will not shift.  

For the most part, it is enough to form a special committee consisting of independent directors and allow them to rely on independent advisors.  In those circumstances, the committee typically receives a high degree of deference.  Shareholders have little or no ability to challenge the decision, even if the committee more or less accepts the offer from the controlling shareholder. 

The court in Americas Mining, however, did not follow the usual script.  The board of Southern Peru formed a Special Committee and staffed it entirely with independent directors.  Moreover, the Committee was "given the resources to hire outside advisors, and it hired not only respected, top tier of the market financial and legal counsel, but also a mining consultant and Mexican counsel."

Nonetheless, the trial court refused to defer to the Committee's decision.  Despite the independence of the directors and the use of independent consultants, the trial court found that the Committee was under the grip of "a controlled mindset" and, as a result, allowed the controlling shareholder "to dictate the terms and structure of the merger."  Said another way, the Chancery Court determined that "although the Special Committee members were competent businessmen and may have had the best of intentions, they allowed themselves to be hemmed in by the controlling stockholder's demands."

The conclusion of a "controlled mindset" did not really arise from any evidence of untoward influence by the controlling shareholder.  It mostly arose out of what the Chancery Court viewed as an inexplicable result.  The Special Committee had apparently been told by its financial advisor that under the terms of the proposed transaction, "Southern Peru would 'give' stock with a market price of $3.1 billion to Grupo Mexico and would 'get' in return an asset worth no more than $1.7 billion." 

Rather than negotiate a change in the sales price, the Special Committee sought to change the assorted valuations.  As the Chancery Court noted:  "[I]nstead of pushing back on [the controlling shareholder's] analysis, the Special Committee and Goldman devalued Southern Peru and topped up the value of Minera."  The result was a valuation placed on Southern Peru that was $1.1 billion below the NYSE market price.  The Chancery Court had this to say about the approach:  

A reasonable special committee would not have taken the results of those analyses by Goldman and blithely moved on to relative valuation, without any continuing and relentless focus on the actual give-get involved in real cash terms. But, this Special Committee was in the altered state of a controlled mindset. Instead of pushing Grupo Mexico into the range suggested by Goldman's analysis of Minera's fundamental value, the Special Committee went backwards to accommodate Grupo Mexico's asking price—an asking price that never really changed.

The Chancery Court, therefore, expected the Committee to ignore the "relative" valuation and somehow go back to the "fundamental" valuation originally provided.  Then, with two disparate sets of valuations, the Committee was supposed to negotiate a better deal with the controlling shareholder.

In effect, therefore, the court found an inexplicable result and concluded that it could only have arisen because of a "controlled mindset."  In truth, however, the Special Committee's actions were not very different from those of most other special committees.  Special committees often approve offers from a controlling shareholder and often rely on advisors that support the terms set out by the controlling shareholder. 

The defendants objected to the trial court's approach.  We'll look at the Supreme Court's reasoning in the next post.  Some primary materials from the Chancery Court are posted on the DU Corporate Governance web site.


Inspection Rights and Delaware Law: Elevating Process Over Efficiency (Central Laborers Pension Fund v. News Corp.)

The Delaware courts constantly come up with new ways of denying shareholders the right to access documents under the right of inspection in Section 220.  The credible basis standard is one.  Central Laborers Pension Fund v. News Corp., 45 A.3d 139 (Del. 2012) provided another. 

Plaintiffs sought documents from News Corp. They sent by overnight mail a request for documents on March 7.  See Complaint, at p. 19 (noting that the letter was delivered to News Corp on March 8, 2011, at 10:09 a.m).  According to the Complaint, the company did not respond within 5 business days and, as a result, they sought enforcement in the Chancery Court.  See 8 Del. C. § 220(c) (where company "does not reply to the demand within 5 business days after the demand has been made, the stockholder may apply to the Court of Chancery for an order to compel such inspection.").  

In considering the inspection request, the Chancery Court took into account that the plaintiffs had simultaneously filed a derivative suit.  The filing of the suit rendered the information sought in the inspection request unnecessary.  As the Chancery Court determined:

As a general matter, by filing its derivative complaint, Central Laborers acknowledged -- if, for no other reason than to satisfy its lawyers' rule 11 obligations -- that it had sufficient information to support its substantive allegations and its allegations of demand futility that would excuse prior demand on the News Corp. board -- both necessary to go down the path chosen by it to challenge the Proposed Transaction. In short, the stockholder plaintiff who files a Section 220 action immediately after its derivative action is acting inconsistently.

The trial court’s reasoning was neither based upon the purpose alleged by plaintiffs nor the paricular documents that could potentially be obtained.  It was a per se rule that the filing of a derivative action cut off the right to inspect.  The Supreme Court characterized the holding this way:  

the Court of Chancery held "[b]ecause Central Laborers' currently-pending derivative action necessarily reflects its view that it had sufficient grounds for alleging both demand futility and its substantive claims without the need for assistance afforded by Section 220, it is, at this time, unable to tender a proper purpose for pursuing its efforts to inspect the books and records of News Corp.”

The reasoning was arguably inconsistent with the holding in King v. Verifone Holdings, Inc., 12 A.3d 1140 (Del. 2011), where the Supreme Court held that the filing of a derivative suit did not cut off inspection rights.  The Chancery Court sought to distinguish the case.  Rather than address the issue, however, the Supreme Court affirmed the denial of the inspection demand but on entirely different grounds.  

The Court focused on the procedural aspects of an inspection demand, particularly the requirement in Section 220 that the demand “shall . . . be accompanied by documentary evidence of beneficial ownership of stock” and “shall be directed to the corporation at its registered office . . . “  The demand submitted by plaintiff contained a number of apparent errors.  See Central Laborers Pension Fund v. News Corp., 45 A.3d 139 (Del. 2012) (“First, the Inspection Demand identified the wrong corporation, stating that it seeks "to inspect and copy the . . . books and records of Viacom and its subsidiaries," rather than that of News Corp.  Second, the supporting materials filed in support of the Inspection Demand were inconsistent", with one affidavit referring to 14,110 shares beneficially owned and another to 14,110 shares owned as record owner). 

But the discussion of these “errors” was mostly gratuitous.  Only one mistake really mattered.  The Court focused on the fact that the demand did not include the account statements that established  beneficial ownership.  The affidavit submitted with the demand referred to an “annexed document” but did not have the "annexed document" attached.  Plaintiff described the failure as a “clerical error” and submitted a revised affidavit and the account statements with the brief opposing the motion to dismiss. 

Despite the fact that there appears to have been no serious doubt about the ownership of the shares and despite the fact that the company at issue had five business days to raise the missing attachent, the Court found that the omission was a sufficient basis for denying shareholders the right to inspect.  The statute, in the eyes of the Court, required that the documentary evidence of ownership be delivered with the demand, not later in the process. 

Having not done so, according to the Court, Plaintiff had to redeliver the entire demand, with the requisite attachments.  Delivering the omitted attachment once litigation had commenced wasn’t good enough.  Id. (“The statute requires the documentary evidence to accompany the demand for inspection. Therefore, Central Laborers' subsequent filing would comply with the statute only if it was submitted with either a new or an amended demand, directed at News Corp’s registered office or principal place of business. That was not done here.”).   

The holding elevates process to an untenable level.  The Court made no mention of the requirement that the company respond within five business days (which it did not, according to the complaint).  Had the company responded, it could have requested the requisite account statements rather than doing so after litigation had commenced.  The holding provides companies with an incentive to withhold procedural concerns over inspection demands until after litigation has been commenced.  In doing so, companies can use the concerns as an affirmative defense in the litigation.

It is an inefficient and rigid view of the statute.  Moreover, it is a decision that decidedly favors management (no penalty for failing to respond within five days) over shareholders (for failing to include the requisite attachment).     

Primary materials on this case are posted on the DU Corporate Governance web site


The Captive Employee Debate (Part 2)

Last week I blogged about the “captive employee” problem (here).  Paul Secunda has described the problem (here) as follows:

[A] lesser-known consequence of [Citizens United] might have a significant impact in the workplace: it may permit employers to hold political captive audience workplace meetings with their employees. Under Citizens United’s robust conception of corporate political speech, employers may now be able to compel their employees to listen to their political views at such meetings on pain of termination.

Stephen Bainbridge took issue with some of my conclusions (here), and I would like to use this week’s post to respond to some of his comments.  Bainbridge first asks:

[H]ow is this different from a union telling its members how to vote? Or, for that matter, the UC system sending me emails about how the world will end if Prop 30 doesn't pass? The notion that a business can't tell its employees that elections have consequences strikes this observer as absurd, not to mention a gross infringement on First Amendment rights. Should the First Amendment really be interpreted as giving pornographers more rights than employers?

I believe it is fair to say that there is a meaningful difference between receiving an email informing the reader of the possible economic consequences of a particular referendum passing, and having one’s employer effectively say, “I will fire some of you if Obama is elected.”  The connection between messenger and executioner in the latter case provides, I believe, a valid basis for distinction.  Furthermore, I believe there is a meaningful difference between receiving an email and being forced to choose between sitting for hours listening to political propaganda or being fired.  In both cases, I believe the threat of termination emanating from one's employer implicates the integrity of our voting system in a way the examples Bainbridge cites are less likely to.  Obviously, there is an empirical question lurking here, but it seems reasonable to assume that threats of termination may coerce people to vote differently than they otherwise would.   This implicates a state interest sufficient to warrant at least some infringement on the employer’s free speech rights, if not a need to recognize an employee’s right not to listen to unwanted political speech.

Bainbridge next complains that:

[B]laming the corporate form is particularly inapt. If the issue is employer pressure on employees, that issue exists regardless of the legal structure of the employer. If you think employers shouldn't be telling employees how government regulation affects business, shouldn't you want to restrict employer speech regardless of whether the employer is structured as a corporation, partnership, or sole proprietorship? Indeed, if we really are living in the age of the uncorporation, as my late friend Larry Ribstein used to argue, growing numbers of employers will be unincorporated. Corporate personhood and Citizens United thus are nothing but red herrings in this debate.

Given that much of the captive audience debate revolves around the First Amendment, it is hard to see how Citizens United can be deemed nothing but a red herring.  I fully expect Citizens United to be one of the first opinions corporate employers cite when confronting state laws seeking to restrict their rights in this area.  Furthermore, corporations are different.  As President Nicholas Murray of Columbia University said in 1911: “I weigh my words when I say that in my judgment the limited liability corporation is the greatest single discovery of modern times . . . . Even steam and electricity are far less important than the limited liability corporation, and they would be reduced to comparative impotence without it.”   My particular focus here is that employers should not be able leverage the unique economic power of the corporate form to attempt to coerce employee’s to vote a certain way.  As I mentioned in my original post: “These business owners were not granted the right to operate in the corporate form so they could pressure employees to vote for particular candidates.  Rather, they were granted the right to operate in the corporate form because of legislative judgments that making incorporation widely available would benefit society as a whole.”  Furthermore, I believe the justifications for this position likely extend to all limited liability entities.  Thus, while I agree with what I believe to be part of Larry Ribstein’s claim regarding the value of a shift to the uncorporation—that is, more skin in the game for managers--I highly doubt a growing numbers of employers will be giving up the state-granted benefit of limited liability any time soon.

Finally, Bainbridge wonders:

[E]ven if you think that incorporation is a privilege, wouldn't restrictions on the speech of senior management be an unconstitutional condition?

I am still in the early stages of getting my head around the unconstitutional conditions doctrine, so I am certainly open to being further educated on this point.  However, what I have learned about the doctrine to this point suggests that it is not nearly as effective a trump card as defenders of corporate political speech think.  I believe one can understand the unconstitutional conditions doctrine (which effectively prohibits the government from impairing constitutional rights indirectly by conditioning the receipt of certain government benefits on a waiver of those rights) as standing in opposition to the greater power doctrine (which provides that the greater power to deny a benefit necessarily includes the lesser power to condition the benefit).  In trying to resolve the seemingly insurmountable tension between these two doctrines, one may be able to look to the concept of germaness, which posits that a condition may be imposed if it is germane to the purpose of granting the benefit.  If this analysis is correct, then I would personally welcome an unconstitutional conditions challenge because one of the primary goals of my scholarship these past few years has been to get people to talk more about the purpose of granting corporate status in deciding First Amendment cases involving corporations.  (For an example, go here.)  At the very least, there seem to be some very legitimate arguments that can be made to tie the regulation of a corporation’s ability to use corporate assets to influence elections to the purposes underlying the grant of corporate status in the first place.  (Please send comments on this point directly to me at spadfie@uakron.edu, because I sometimes miss the comments that are entered below the posts.)


Caps on the Size of Big Banks: Another Voice Weighs In

We've discussed the issue of bank regulation on this blog from time to time.  With a handful of banks holding the lions share of the assets in the financial system, the problem of too big to fail remains in place.  Two broad solutions exist.  One is to downsize the large financial institutions so that they are not too big to fail.  The approach is complex.  No one really knows what the optimal size of a bank should be.  Moreover, there is no particular agreement on the method.

The other is to impose additional prudential requirements designed to reduce the risk of failure.  The banks will still be too big to fail but will be less likely to fail.  The Volker Rule is an example of regulation in this category.

Daniel Tarullo, a government of the Federal Reserve Board, has weighed in on this issue.  He has called for limits on size (the speech is here).  Specifically, he has called for a limit on total non-deposit liabilities.  As he proposed:

The idea along these lines that seems to have the most promise would limit the non-deposit liabilities of financial firms to a specified percentage of U.S. gross domestic product, as calculated on a lagged, averaged basis. In addition to the virtue of simplicity, this approach has the advantage of tying the limitation on growth of financial firms to the growth of the national economy and its capacity to absorb losses, as well as to the extent of a firm's dependence on funding from sources other than the stable base of deposits.

In other words, banks would incur a limitation on their non-deposit sources of funding, effectively limiting their size.  According to the WSJ, Tarullo "is the highest ranking regulatory official to call for limiting the size of banks."

The approach raises plenty of questions, as Tarullo himself noted.

Of course, the difficult question would be the applicable percentage of GDP. The answer would depend on a judgment as to how much of an impact the economy could absorb. It would also entail a judgment as to how large and complex a firm needs to be in order to achieve significant economies of scale and scope that carry social benefit. Depending on the answers to these questions, there may be a need to balance the relevant costs and benefits. There would also be important secondary questions such as whether to exclude from a firm's calculated liabilities only insured deposits and which asset base to use in calculating non-deposit liabilities.

Whether these sorts of reforms will ever occur remains to be seen.  But it reflects a growing sentiment that the problem of too big to fail was not solved by the reforms in Dodd-Frank. 


The Fiduciary Limits on "Special Interest" Directors: Shocking Technologies v. Michael

One of the complaints about giving shareholders greater ability to nominate (and elect) their own candidates to the board is that they will elect "special interest" directors.  These are directors who are nominated by particular shareholders and who are expected to support the interests of the nominating shareholders rather than the interests of all shareholders. 

There are many many problems with this concern.  It ignores the need for the candidate to obtain support from other shareholders, something more difficult if the nominee looks like it won't represent the interests of all shareholders.  It also ignores the fact that directors have fiduciary obligations to all shareholders, not just those who submitted the nomination.

Fiduciary obligations to all shareholders, however, arguably provide reduced comfort given their amorphous nature.  Directors can favor almost any position (including those supported by the shareholder who submitted their nomination) and assert that it is consistent with fiduciary obligations.  Thus, to some degree, fiduciary duties do not impose meaningful limits on the behavior of individual directors. 

Shocking Technologies v. Michael, 2012 Del. Ch. LEXIS 224 (Del. Ch. Sept. 28, 2012), suggests that this may not be true.  The case did not involve a special interest director but did, nonetheless, clarify that there are substantial limits on the unilateral behavior of individual directors. 

In that case, the director at issue sat on the board of a start up.  A shareholder had the right to exercise warrants.  The exercise would, according to the court, provide the company with a much needed source of capital.  As the court described, the director "attempted to keep [the shareholder] from exercising the warrants in accordance with their terms and to persuade [the shareholder] to negotiate an even better deal—whether in terms of price or in terms of an additional board seat—before it exercised the warrants or made additional investments in Shocking."

The director's "actions clearly demonstrated a desire to interfere with the Company's funding."  The court viewed the behavior as disloyal.  See Id.  ("The best interests of the Company—finding enough cash to survive—were immediate and unmistakable. [The director], knowing the consequences if he was successful, acted against the Company's best interests. For that, he was disloyal.").  The court went on to conclude that the company had not shown damages.  In addition, the court declined to aware fees, finding an absence of bad faith. 

The court did not discount the right of directors to disagree or to seek to "change corporate governance ambiance and board composition."  Nonetheless, there were limits. 

A director may not harm the corporation by, for example, interfering with crucial financing efforts in an effort to further such objectives. Moreover, he may not use confidential information, especially information gleaned because of his board membership, to aid a third party which has a position necessarily adverse to that of the corporation.

The case stands for the broad proposition that fiduciary obligations impose limits on the behavior and activities of individual directors and require that director remain loyal to the corporation. 

In the context of "special interest" directors (not something present in this case), the decision suggests that directors nominated by a particular shareholder will be subject to claims of disloyal behavior if they overtly favor the nominating shareholder.  This significantly weakens the argument that directors nominated by particular shareholders will act in a manner that favors the nominating shareholder at the expense of the other owners. 


Severance, Waste and In re HP Derivative Litigation

We examined the law around severance packages paid to departing CEOs in the absence of an employment agreement in Seinfeld v. Slager.  The court in that case validated the payment on the basis of a general release and past service, justifications always present.  We noted that in Zucker, the Delaware Chancery Court essentially found that the amount paid as severance could not be challenged as waste where the board was independent and had used proper process.

The federal district court in In re HP Derivative Litigation, 2012 U.S. Dist. LEXIS 137640 (ND CA Sept. 25, 2012) largely made the same points. 

The litigation arose out of the departure of Mark Hurd as CEO from HP.  At the time of Hurd's departure, he had no employment agreement.  The board nonetheless executed a Separation Agreement that provided benefits allegedly valued at $53 million.  Plaintiffs alleged that the benefits constituted waste.  

The court, however, found that plaintiff had not adequately plead a claim for waste.  The court noted that a finding of waste was "inappropriate '[s]o long as there is some rational basis for directors to conclude that the amount and form of compensation is appropriate and likely to be beneficial to the corporation'".  The Separation Agreement contained "confidentiality, non-compete and non-solicitation covenants" clauses and provided for a waiver of claims. 

In discussing the waiver, court summarily dismissed claims by plaintiffs that the provision provided no meaninful benefit to the company. 

  • Plaintiffs' argument ignores that if the Board had not negotiated the terms of Hurd's departure and instead had fired him for cause or denied him severance, Hurd could have sued, bringing a claim for wrongful termination or violation of the Severance Plan. . . . The Release protected against the expense of litigation and negative publicity resulting from having to defend against such a claim. That is, even if the release was worth relatively little, Plaintiff overstates his case to say it was worthless.

Moreover, even without the consideration, "at least some portion of Hurd's severance could represent 'reasonable' compensation for his successful past performance."    

Plaintiff was, therefore, left with arguing that the amount paid was excessive.  Relying on the reasoning in Zucker, the court dismissed the claim. 

  • "[T]he size of executive compensation for a large public company in the current environment often involves large numbers," and "amount alone is not the most salient aspect of director compensation" for purposes of a waste analysis. Without question, the amount of Hurd's severance may appear extremely rich or altogether distasteful to some. But, "[t]he waste doctrine does not . . . make transactions at the fringes of reasonable decision-making its meat." Rather, "[t]he value of assets bought and sold in the marketplace, including the personal services of executives and directors, is a matter best determined by the good faith judgments of disinterested and independent directors, men and women with business acumen appointed by shareholders precisely for their skill at making such evaluations." Thus, allegations that the payments and benefits Hurd received were valued at approximately $53 million are alone insufficient to demonstrate waste. (citations omitted)

The analysis reiterated what Zucker had already made clear:  All severance arrangements with departing CEOs were supported by consideration and allegations of waste would not be allowed to go forward based upon the amount paid. 

In concluding that past consideration was sufficient to justify at least part of the severance, the court did not analyze or even note the compensation packages received by the departing CEO in the past.  According to the HP proxy statement filed in 2010, Hurd had received total compensation of $30 million in 2009, $42 million in 2008, and $25 million in 2007.  In other words, the court did not find it relevant to even examine prior pay packages before determining whether severance was appropriately paid for past performance to the company. 

The federal court in this case applied Delaware law.  The standard does not permit meaningful review of severance packages paid to departing CEOs.  As a result, the state law standard exerts no downward pressure on severance amounts.  Any effort to reduce amounts paid as severance will need to percolate up from Congress (see say on pay, clawbacks, and the regulation of Compensation Committees of exchange traded companies).


Waste, Severance, and importance of "Creative Counsel" -- Zucker v. Andreesen

Zucker is a case we have already discussed.  Go here, here and here.  Nonetheless, it is worth revisiting in connection with our discussion of the standard of review for severance packages.  We noted in Seinfeld v. Slager that the court all but held that past service to the board and general waivers would be sufficient to justify the payment of severance. 

Zucker arose out of the departure of Mark Hurd from HP.  Although not having an employment contract, he received severance benefits allegedly valued at $53 million.  The plaintiff challenged the payments as waste.  Plaintiff argued that the execution of a "waiver" was not sufficient consideration to justify the payments. 

Although the court found that plaintiff was entitled to a presumption that the court could have terminated the CEO for cause, the court found that "there is no allegation from which the Court reasonably can infer that Hurd necessarily would have acquiesced in such a decision."  Moreover, "[c]reative counsel advocating on Hurd's behalf could have claimed that he, in fact, was entitled to severance under HP's general executive officer severance plan notwithstanding the expense report violations."  As a result, while the board "might have prevailed," the company could have been required to "incur considerable costs of time, resources, and negative publicity in the interim."  

In other words, the argument that the waiver was worthless because it was the board that had possible claims, not the CEO, was rejected by the court out of hand.  It was enough that "creative counsel" could still find a way to file a claim (presumably while avoiding the risk of sanctions under Rule 11).  Moreover, irrespective of the value of the waiver, the company "arguably still could have compensated him for his past stewardship of HP."  

As for the argument that the amount was excessive, the court found that the amount was actually not the determining factor in a claim for waste.   

Plaintiff's waste claim reduces to his belief that $40 million was just too much. Be that as it may, "the size of executive compensation for a large public company in the current environment often involves large numbers," and "amount alone is not the most salient aspect of director compensation" for purposes of a waste analysis. Without question, the amount of Hurd's severance may appear extremely rich or altogether distasteful to some. But, "[t]he waste doctrine does not . . . make transactions at the fringes of reasonable decision-making its meat." Rather than by judicial predilection, "[t]he value of assets bought and sold in the marketplace, including the personal services of executives and directors, is a matter best determined by the good faith judgments of disinterested and independent directors, men and women with business acumen appointed by shareholders precisely for their skill at making such evaluations." 

In other words, even a "distasteful" payment would be upheld if the process used by the board was adequate. 

The case, therefore, stands for the proposition that severance packages paid to departing CEOs who do not have a compensation agreement cannot be challenged due to a lack of consideration and cannot be challenged because the amount is excessive.  In other words, the outer limits set by the waste doctrine in the context of severance agreements are no limits at all.  The Delaware courts, therefore, do not intend to impose any limits on these payments.  To the extent that limits are imposed, as we have noted earlier, they will have to be imposed by the federal government. 


Seinfeld v. Slager and "Limits" on Directors' Fees (Part 3)

We are discussing Seinfeld v. Slager, 2012 Del. Ch. Lexis 139 (Del Ch. June 29, 2012). 

The other issue that arose in Seinfeld was the decision by the board to grant itself "restricted stock units" under the company's stock plan.  According to the allegations, outside directors in 2009 received total compensation of between $843,000 and $891,000.  Of that amount, $743,700 came in the form of awards under a stock incentive plan "administered by administered by a committee of non-employee members of the Board or if no committee exists, by the Board itself."  As the court noted: "The Defendant Directors are participants in the Stock Plan, and pursuant to it have awarded themselves time-vesting restricted stock units."  

The Plaintiff challenged the fees as excessive.  In determining the standard of review, the court focused on the allegations that the directors had awarded themselves stock units under the stock plan.  A prior decision had found that even where this occurred, the applicable standard was the business judgment rule. 

Plaintiffs, however, argued that the plan lacked "sufficient definition to afford" directors the protections of the BJR.  The court agreed. 

The Stock Plan before me puts few, if any, bounds on the Board's ability to set its own stock awards. The Plan itself provides that the Committee, comprising the Directors themselves, has the sole discretion, in terms of restrictions and amount, over how to compensate themselves. In regard to restricted stock, the limitations upon the Board are that it can only award 10,500,000 shares total and award an Eligible Individual 1,250,000 shares a year. . . . Assuming that there were 12 directors, the Board could theoretically award each director 875,000 restricted stock units. At $24.79, the award to each director would be worth $21,691,250 and the total value would be $260,295,000.

Nor did shareholder approval change the outcome.  See Id.  ("A stockholder-approved carte blanche to the directors is insufficient. The more definite a plan, the more likely that a board's compensation decision will be labeled disinterested and qualify for protection under the business judgment rule. If a board is free to use its absolute discretion under even a stockholder-approved plan, with little guidance as to the total pay that can be awarded, a board will ultimately have to show that the transaction is entirely fair."). 

The lack of standards in the stock plan did not result in a finding that the fees were, in fact, excessive.  Instead, it imposed on the board the obligation to show fairness.  The board would still have an opportunity to show that the fees were not excessive in fact.  Nonetheless, the case was allowed to go forward.  

The decision did not portend any meaningful judicial review of directors fees or any meaningful downward pressure on the amount of fees.  The take away is simply that companies should include more meaningful limits on board discretion in stock plans.  To the extent boards are not in a position to award themselves shares or options that could be characterized as "excessive," the standard of review in Delaware is likely to remain the business judgment rule. 

Primary materials on the case have been posted at the DU Corporate Governance web site